Business equivalency rate: Fairness for pass-through businesses

Equal rates for all businesses
Pass-throughs represent the fastest growing and most important segment of the economy.

Tax reform proposals that reduce corporate tax rates without equal treatment for pass-through businesses would exacerbate an uncompetitive environment and unnecessarily penalize pass-throughs solely on the basis of their form.

Grant Thornton LLP believes all business income should be taxed equally. Competitive business tax rates are critical for spurring domestic business investment and job creation. Yet, under our current tax code, corporations are taxed at lower rates than pass-through businesses even though both types of businesses face the same global economic pressures and challenges.

Grant Thornton urges support for providing a lower rate on the active business income of pass-throughs, as proposed in the House Republican Blueprint and the Main Street Fairness Act (H.R. 116 and S. 707).

Independent third-party wage certification
Tax parity does not mean that wage income can be freely converted to a lower rate. Appropriate rules can and should be established to prevent gaming the system. Those rules, however, should be flexible enough to accommodate for modern enterprise, by allowing a business to continue to be able to prove that wage compensation is reasonable, or elect a safe harbor to reduce tax controversies.

The business entity is required to determine the amount of the distribution that is considered to be reasonable compensation. If the compensation were certified by an independent third-party and determined to be reasonable, it would eliminate abuse and the potential revenue loss if individuals were to count their compensation as business income.

A third-party could certify reasonable compensation by establishing facts and circumstances related to whether the compensation is comparable to individuals in similar industries and, geographic areas, or with similar work-related duties much like they do today under clearly established standards and law. The third party must certify the amount claimed, and that amount would not be less than the historic compensation of the individual unless the services performed were reduced. Any remaining ordinary income attributable to the entity would be treated as qualified business income.

Include all investors as a part of tax reform
Congress would do well to focus on whether or not the business entity itself is active. An active trade or business would meet the definition currently in the tax code. An active trade or business exists if the entity carries on activities for the purpose of earning income or profit. Such activities generally must include the collection of income and the payment of expenses. The active conduct of a trade or business does not include the holding, for investment purposes, of any debt, stock, security, land or other property, or the leasing of real or personal property unless the entity or its owners perform significant services in connection with the property.

Beyond the active trade of the business entity, Congress should also focus on the role of investors, which the tax law classifies as being active or passive. Active investors may be part of the management of the company and would likely draw a payment from the business. Passive investors, however, provide no services and would not draw any payment. All of their earnings from the company are a return on their investment, the same as if they had invested in and were receiving dividends from a regular corporation. Both types of investors should face an equal tax rate when deciding among potential investments. Any disparity will cause investors to lean toward investments with lower tax rates that yield a greater rate of return.

Although passive investors may not be involved in the day-to-day operations, the capital they provide can be as critical to the future growth and success of a business as its daily management. Taxing the return on their pass-through investment at a higher rate than would apply if they invested the same capital in a corporation means that investors will choose to invest in the corporation, leaving the pass-through at a competitive disadvantage in the raising of necessary capital. Different tax rates will create a unique problem for pass-throughs, particularly S corporations, who may lose their status. If the differential in rates is large enough, it may even result in an avoidance to invest in pass-through investments. To prevent this, the same tax rate should apply to a passive investor’s return on investment, whether that investment is in a business organized as a corporation or as a pass-through.